The Initial Coin Offerings Market

Notes from the VaultLarry D. Wall
March 2018

Initial coin offerings (ICOs) have become been one of the most talked about developments in the financing of technology firms. The cryptofinance research firm Smith and Crown's "Token Sales in Review (Part 1)" estimates the amount of money raised by ICOs jumped from about $100 million in 2016 to over $6.5 billion in 2017. However, along with this increased activity came increased scrutiny by securities regulation authorities. For example, former Securities and Exchange Commission (SEC) member Dan Gallagher was recently quoted saying ICOs are akin to the "Wolf of Wall Street on steroids."

This post is the first of a two-part series examining some of the economic issues associated with ICOs. The first part discusses the ICO market itself. What is an ICO? What types of tokens are sold in ICOs? What does the ICO sales process look like? What happens to the tokens after the sale? The second post will compare ICOs with alternative ways for tech firms to raise capital, including angel finance, venture capital (VC), and crowd financing.

What is an ICO?
There is no official definition of an ICO. The law firm Clifford Chance defines it in a report: "An ICO is a fundraising event in which an issuer/operator offers tokens to participants in return for consideration (funds, or as a reward for marketing or referral efforts)." In practice, the ICOs undertaken to date commonly share a number of characteristics: the issuers tend to be start-up firms, the tokens issued tend to involve the presale of a product to be developed, and the token sales occur on a blockchain.

The acronym ICO appears to be a deliberate play on IPO, the acronym for initial public offering. An IPO is the first sale of a corporation's equity to the general public. Although the differences between current ICO market practices and the requirements for an IPO will be discussed in greater detail below, two important differences stand out. First, although the digital asset offered in an ICO could, in principle, be stock in the firm as with an IPO, in practice, it is almost always something else. Second, an IPO conducted in the United States would necessarily implicate U.S. security laws, whereas ICOs are almost always structured with the intent of avoiding these regulations. The (currently presumed) ability of ICOs to avoid U.S. security laws has a variety of implications for the range of possible ICO structures and post-ICO trading in digital assets. One of the most important implications of not following the requirements for an IPO is an ICO can be used by a firm to raise funds far earlier in a firm's life cycle than would ordinarily be possible with an IPO.

Who issues tokens and what are their uses?
In general, the firms issuing ICOs tend to be small start-up firms in the technology industry. The first ICO is generally attributed to Mastercoin (now called Omni) in July 2013, a firm that was developing a software layer on top of the Bitcoin blockchain. Relatively few new transactions took place until 2016, but the market for ICOs saw rapid growth through 2017, according to CoinDesk ICO Tracker. The figure "Number of Token Sales/ICOs" in Smith and Crown's "Token Sales in Review (Part 1)" suggests over half of the 575 token sales in 2017 took place between September and December.

Although the ICO market is rapidly evolving, we can gain some insight into it in a recent paper by Saman Adhami, Giancarlo Giudici, and Stefano Martinazzi. The paper summarizes the characteristics of a sample of 253 campaigns that occurred from 2014 to August 2017. Over 81 percent of the firms in the authors' sample had successful ICOs in the sense of reaching their minimum funding goal. The paper finds the most common country of origin was the United States at 19 percent and that another 12 percent adopted a decentralized governance approach that resulted in no single country of origin. The types of products seeking financial backing in the authors' sample varied widely with financial services/fintech the most common by number (16 percent), followed by smart contracts, high-tech services, marketplaces and exchanges, and investments/VCs/incubators. Subsequently, the Smith and Crown report "Token Sales in Review (Part 2)" finds for its sample of 2017 ICOs raising at least $25,000, the leading industries were finance, media, and information.

The tokens issued in ICOs could represent a wide variety of assets to the token buyer, in principle, even common equity in the firm selling the tokens.1 In practice, according to Smith and Crown's "Token Rights: Key Considerations in Crypto-Economic Design," tokens are actually "not like company shares: they are much weirder." In the sample of ICOs studied by Adhami, Giudici, and Martinazzi, most tokens provide "exclusive access" to the services being offered by the project, but they do not provide any rights to either the governance of the firm or the firm's ultimate profits. Tokens that provide such exclusive access are sometimes called "app coins," "protocol tokens," or "utility tokens." The report "Token Rights" cited above provides more details about the rights associated with utility tokens, which often take one or more of the following forms: (a) the token is the sole way to make payment for a product, (b) the token provides access to the platform, (c) the token is needed to play certain roles on the platform, and (d) the token determines who secures the blockchain.

One advantage of selling utility tokens is they can help in developing demand for the service being provided by the issuer. At a minimum, the sale of utility tokens may effectively amount to the presale of the issuer's forthcoming product, providing a potential source of demand when the product becomes available.2 However, tokens that are essentially a presale of the firm's product may perform a more valuable function for the seller to the extent they draw people into their networks. The value of many networks increases with the number of participants, and so if the tokens attract participants to the issuer's network, it is increasing the value of its product and thereby increasing demand from token holders and others. For example, a paper by Deloitte's Rob Massey, Darshini Dalal, and Asha Dakshinamoorthy emphasizes the potential value to ICO issuers of designing their utility tokens to build a network of users.

Most of the firms participating in ICOs appear to be relatively new. A paper by University of St. Thomas professor Wulf Kaal and Groningen Center postdoctoral fellow Marco Dell'Erba comments: "The better ICO companies may have a proof of concept or an alpha version before starting the token sale, and sometimes even a beta version." However, the general structure of ICOs permits their use by firms that have previously raised venture capital and already have a marketable product. For example, Kik Interactive, a firm providing a mobile messaging app, raised almost $100 million in an ICO in 2017.3

What happens during the token sales process?
In principle, the process of selling tokens in an ICO could follow a wide variety of formats given the tokens are (almost) always issued outside existing securities law. However, ICOs come with no legal guarantee the firm will be able to deliver a product or even necessarily intends on delivering a product (that is, the token sale may be a fraud). Thus, token sellers generally need to persuade potential token buyers the funds will be used to produce a service that will be valued by token holders.4 Otherwise, there is a realistic possibility that the ICO will not raise the intended amount of funds. An article by Bitcoin.com reporter Kai Sedgwick states that 142 of 902 sales he studied failed at the funding stage in 2017. Moreover, this risk of failure may be increasing over time, with EY Research finding a steady decrease in projects hitting their fundraising goals from June to November 2017. This risk of failure provides some pressure for issuers and their advisers to identify and follow practices that have proven successful, which would create a degree of standardization in the market.

Kaal and Dell'Erba provide a timeline often followed by ICOs. First, the project is announced and an executive summary is issued. After receiving investor comments, the management team/promoter issues a white paper with more detailed information on the project and key terms of the ICO. Additional detail about the technical specifications is then provided in a "yellow paper." The token sales begin with a pre-ICO preliminary offer to selected investors. After that, the ICO is launched and people can begin buying the tokens using Bitcoin (or Ether or some other cryptocurrency).

Those undertaking an ICO may take a variety of steps to increase their chances of success. As noted earlier, they may have completed a proof of concept or even gone so far as to have a beta version of the product. They may also reveal information about their management team. Additionally, lawyers and consultants may be brought in to advise prospective issuers on how to structure the ICO to increase the chance of a successful launch and reduce the risk the tokens will later be labeled as securities for the purposes of existing securities law. Jason Goldberg, chief executive officer of Ost.com (a firm building a blockchain tool kit for other firms), provides some detail in a post about the $2 million spent preparing for his firm's successful token sale, including the use of two major law firms, a big four accounting firm, and three economists. Goldberg also mentions the need to fight off "dozens of highly sophisticated scammers" who sought to have Ost.com's token buyers send their funds to the scammers' accounts.5

An important issue associated with the token sale process is whether these sales constitute the issuance of a security. ICOs are typically structured as the sale of utility tokens rather than traditional securities in an attempt to avoid securities regulation.6 However, SEC chairman Jay Clayton testified in February 2018 that in his view "by and large, the structures of the ICOs that I have seen involve the offer and sale of securities that directly implicate the securities registration requirement and other investor protection provisions…" In a related development, the SEC has reportedly contacted some potential issuers in recent months, resulting in more than a dozen firms shelving plans to raise money from investors, according to Robert Cohen, head of the SEC's cyber enforcement unit.

Ultimately, the question of when an ICO token sale becomes the issuance of a security may need to be settled in court. How the issue is resolved may have implications not only for the future of the ICO market but for the participants in some already completed ICOs.7 SEC chairman Jay Clayton's January 2018 speech includes remarks interpreted as warning that some lawyers may be breaching their professional obligations when advising on token sales, according to an article by Fortune reporter Jeff John Roberts. Moreover, Jared Marx, an attorney at Harris, Wiltshire & Grannis, notes the Securities and Exchange Act of 1933 allows the buyer of an unregistered security to sue the seller to get his money back, and the 1933 act provides for personal liability on the part of the seller.8

What happens after the sale of tokens?
After a successful fundraising campaign via a token sale, the buyers of the tokens may either retain the tokens to obtain whatever services their token provides or sell the tokens to other potential users and investors. Given the large fraction of ICO campaigns to raise funds for developing a product, it is not surprising the Token Report finds less than 10 percent of the tokens in its sample are currently usable (according to an October 2017 article by Bloomberg reporter Olga Kharif). Moreover, in those cases where there is no usable product at the ICO, there is a real risk there will never be a usable product. In some cases, the product may not be delivered because of problems with the underlying technology, execution problems by the firm's management team, or competition from other similar products. However, some ICOs may also turn out to be frauds where the promoter never intended on delivering a real product.9
Bicoin.com reporter Kai Sedgwick found that 276 of the 902 sales he analyzed have failed and he classified another 113 as "semi-failed" because either the team had stopped communicating on social media or their community is so small "the project has no chance of success."

If token holders choose to sell their tokens, they need to find a buyer. The willingness of others to purchase a token is likely to depend on any additional information that has come out since the completion of the ICO. Although it's possible to arrange direct sales, the most common approach is to sell the token through an exchange (that is, if the token is listed on an exchange).

Conclusion
ICO token sales have become a popular way for start-up technology firms to raise capital. These token sales are typically structured as a presale of a product in development in order to avoid U.S. securities law and to help build demand for the firm's product. In some cases, the token seller has provided minimal information about the intended product. However, potential token buyers can and have refused to subscribe fully to tokens for projects where they are not persuaded of the project's ultimate value. My next post will compare ICOs with other common ways of funding new technology related ventures.

Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Scott Frame, Brian Robertson, and Warren Weber for helpful comments. The view expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.

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1 An article by Tom Benson, CEO of Pathfinder Equity Systems, discusses the potential for an ICO to replace IPOs as a way of exiting VC portfolios.

2 However, an article by Gregory Simon, CEO of Loyyal Corporation, points out that to the extent a utility token is the presale of a service, that raises some issues about how to account for the initial token sale and when the proceeds from the tokens should be recognized as revenue in the firm's financial statements.

3 See Rimon partner Dror Futter for a discussion of some of the legal issues associated with VC-backed companies undertaking an ICO.

4 However, there is an exception to this standard practice. The creator of the Useless Etherium Token clearly stated there was no intent to produce a product. The token's homepage asserts it raised the equivalent of $232,392 as of March 8, 2018.

5 EY Research found a stunning 10 percent of ICO funds were lost to hackers' attacks.

6 A number of papers discuss the legal considerations under both U.S. securities laws (for example, see here, here, here, and here,) and foreign laws (see here and here). See also see the International Organization of Securities Commissions' page linking to various securities regulators' statements.

7 An additional concern for new and completed ICOs is the risk they may be subject to the Bank Secrecy Act's provisions related to anti-money laundering/combating the financing of terrorism. A February 13, 2018, letter from Drew Maloney, assistant secretary for legislative affairs to Oregon Senator Ron Wyden, indicates that ICO coins or tokens must register as a money transmitter and comply with relevant provisions of the Bank Secrecy Act. Peter Van Valkenburgh, the director of research at Coin Center, notes that failure to comply is a federal felony. However, John-Paul Thorbjornsen, the chief executive officer of Canya, is quoted in an article by Business Insider reporter Frank Chaparro saying that most ICOs since August 2017 have registered and complied with the law.

8 See also a discussion by Grant P. Fondo and other lawyers at Goodwin of the potential for individuals to be liable for assisting in the sale of unregistered securities.

9 An article by Brian Kean of the investment evaluation firm ICORating discusses five of the largest ICO frauds.